In order to satisfy Regulation D or applicable crowdfunding rules, the issuer must typically make significant disclosures regarding the parameters and characters of the offering and critically, the associated risk factors. The ultimate disclosure document is typically dubbed a “Private Placement Offering Memorandum” or “PPM”. One of the PPM’s core functions is to provide investors with all of information reasonably necessary to insulate the company against claims of securities fraud.
This is due to the fact that while private placement offerings are typically exempt from the onerous registration requirements of publicly traded securities, the issuers are still subject to the anti-fraud provisions of the securities laws. In the event the private placement memorandum for a private placement offering is misleading /erroneous, or makes material omissions regarding the offering or risk factors, the issuer’s principals as well as broker-dealers may be in violation of the securities laws’ anti-fraud provisions. That in turn can lead to personal liability against the principals and other parties for investor monies.
The following is a summary breakdown of some of the most important Private Placement Offering Memorandum sections:
Securities Notices to Investors.
This section typically opens the PPM and contains extremely prominent and important disclosure legends informing prospective investors that the offered securities are not registered with the SEC and/or applicable state analogues.
Potential and Actual Investment Risk Factors.
This is one of the most critical sections of the PPM and is the first defense against fraud allegations by investor and third parties. This section expansively and thoroughly lays out the actual and potential threats the issuer may face that result in unfavorable returns to the investor or total loss of investment. Such risks are often bifurcated to address industry wide risks and risks that pertain to the specific issuer. Business related risks typically include industry level concerns, such as risks that are native to the specific industry, and/or uncertainty within the business environment overall. Conflict of interest risks are often delineated in this section as well, such as relationships with other entities such as parent and affiliate companies and/or service providers, such as legal. This section typically requires the review of attorneys with PPM and private placement offering experience to assure maximum efficacy.
The executive summary, or management summary, is a brief section that summarizes the investment proposal to facilitate the investor’s rapid understanding of the overall issuer’s business, management, and investment terms. Moreover, it is intended to assist investors in decision-making. It also commonly contains a brief statement of the business opportunity and a summary of the various documents involved in the offering process.
Since typically the issuer delegates management authority and oversight duties to a select group of managers or officers, it typically discloses the biographies of these parties for disclosure and information purposes. Hence, the PPM gives the investors an idea of whom is managing the company, what experience they have, and how successful they have been in order for the investors to consider the company’s management skills when deciding whether or not to invest. Critically, however, PPMs typically disclaim prior management success as a predictor of future success.
Financing Plan and Capitalization.
The PPM gives the investor information about the company’s financial situation, objective, and strategies. The PPM may also provide information on the company’s current capitalization (e.g., what other securities are issued and outstanding).
Terms of the Offering and Type of Interests Offered.
The PPM discusses the type of security being offered (e.g., shares versus units, preferred versus common, debt etc.), proposed investor investment terms, and return on investment after certain contingencies or conditions occur, (e.g., parri passu status, distribution or dividend preferences, preferences on liquidation, conversion rights, dividends or interest, current pay or accrued, warrants, collateral, affirmative and negative covenants, etc.). Often a so-called “waterfall” may be included, which lays out which party shares in company revenues, at what point, and for how long, before another class of parties or securities may do the same.
The PPM discusses similar transactions to inform and illustrate the kind of outcomes that have resulted from similar situations and the type of market the company is in so the investor can make an informed decision. However, PPMs typically disclaim prior management success as a predictor of future success.
The PPM will often specify a minimum investment amount for an investor which may be a single or multiple of the type of security offered (e.g., shares, units, notes, etc.). This is usually done to prevent an influx of too many investors, which may carry additional overhead, reporting, and liability.
The PPM commonly discusses restrictions on the transfer of securities which is a core requirement in private placement offerings and crowdfunding (often referred to as “restricted securities”). In short, investors may not freely sell their securities in the open market, but must rather comply with specific securities law exemptions, such as SEC Rule 144.
The PPM will often lay out the proposed taxation profile of the issuer entity (e.g., corporate taxation, or partnership taxation) and advise investors there is a risk the IRS may reclassify such profile.
Accounting and Reports.
The private placement memorandum may also commit management to furnish certain financial and other reports to investors on a periodic basis (e.g., quarterly or annual) to inform investors of company operations and/or provide them the necessary information to complete their tax returns.
The PPM discusses the procedure a prospective investor must undertake to become an investor and how such party may qualify to become an investor. This section also typically lays out the exemption investor qualification standards and makes clear that a potential investor must meet these standards in order to make an investment. Typically, this means the investor is an “accredited investor” under SEC Rule 501, with the financial assets and income stream necessary to potentially absorb the loss of the investor’s entire investment. Failure to demonstrate the issuer informed investors of such qualifications can result in violations of the Regulation D and/or crowdfunding exemptions, since these exemptions typically severely limit the number of non-qualifying investors who may invest.
A Private Placement Memorandum is an important document in order for the company to raise capital via private securities offerings and/or crowdfunding. It is important that the company make all necessary disclosures to avoid personal liability, criminal sanctions, and restrictions from raising capital.